National Institute of Economic and Social Research

Monday, 16 January 2017

Interviewed for ITN/Channel 4 News, I was asked – very
reasonably – why anyone should listen to economists’ views on the economic
impacts of Brexit, when many short-term forecasts that a Brexit vote would lead
to a sharp slowing of the economy had been proved wrong. This was my response:

“Short-term economic forecasting
is very unreliable. Just because the weatherman gets it wrong about whether
it’s going to snow tomorrow doesn’t mean that the scientists have it wrong
about whether climate change is going to make the planet warmer over the medium
to long term”

But they were (mostly)
wrong. On the markets, while the pound
did indeed fall much as expected (which is actually good for economic activity
in the short-term; the exchange rate acts a shock absorber to the expected long
term hit to the economy by making UK exports cheaper) market interest rates
didn’t rise and the stock market didn’t collapse (although UK companies have
certainly underperformed). More importantly, after an initial shock to
confidence, businesses and consumers appear to have decided that nothing has
happened yet and nothing much will happen for a while; so it’s business as
usual. Research on uncertainty, it turns out, isn’t exactly a certainty.

We can dismiss a
couple of excuses for this failure. It’s true Brexit hasn’t happened yet – but
the forecasts were explicitly related not to Brexit, but to the uncertainty and
expected future impact of Brexit. It’s true some (but not all) of the forecasts assumed immediate Article 50 notification,
but that was not central – and if it was uncertainty that was supposed
to drive economic weakness, delaying notification merely prolongs the
uncertainty. And it's true there was a policy response from the Bank of England - but if anything could have been forecasted it was that.

So what forecasters
fundamentally got wrong was their judgement about the short-term behaviour of
millions of individuals interacting in a very complex system, where (as we know
from the analysis of such systems) relatively small changes in a few variables
can lead to quite different outcomes. The
claim that “the flap of a butterfly’s wing in Brazil can set off a tornado in
Texas” is poetic
license – but the inherent difficulty of forecasting short to medium term
perturbations is true both of the economy and the weather.

Now, despite these
difficulties, weather forecasting has got considerably more reliable over the
last 20 years, so there’s plenty of room for economic forecasters to improve –
but explaining how the economy will do
in the next few months is always likely to be very challenging. That’s true of
economic forecasting in “normal” times: but it’s even more so the case when
trying to assess the short-term impacts of a political event on the
psychological attitudes of consumers and investors.

By contrast, predictions
about the long-term impact of Brexit – like climate science - are based on quite different reasoning,
about how changing one key factor – our openness to trade, or the degree to
which the earth’s atmosphere retains heat – changes the long-run properties of
the system. The methodologies used are
well-established and robust – and while of course the detailed modelling of
their impacts requires considerable expertise and huge amounts of data, the
basic mechanisms at work are well-established and easy enough to explain. The operation of the greenhouse effect can be
demonstrated in a school lab.

Similarly, the basic
insights of the “gravity model” approach to predicting international trade –
that trade between two economies depends on how big each is, how far apart they
are, and historical, cultural and policy factors including the existence of
special trade arrangements like the EU – are common sense, and their empirical
and practical validity is not seriously in question. More CO2 will make us hotter: less trade and
migration will make us poorer.

Now, economists’ forecasts
of the long-term impacts of Brexit could still be wrong – or inaccurate- just
as climate scientists could be wrong about the path of climate change. First,
our scenarios could be wrong; Brexit could turn out very differently from the
options (hard or soft, clean or chaotic) most people are trying to analyse;
similarly, sudden technological advances could change the path of CO2
emissions. Second, the numbers are
probably more uncertain even more than the models (which already incorporate some
forms of uncertainty) suggest – some forms of uncertainty are simply impossible
to model.

So while we can predict
that Brexit will reduce growth and CO2 will warm the planet, we should take the
quantitative modelling on just how large these effects are with a large pinch
of salt. In particular, feedback effects
could either amplify or dampen the impacts – and it is very difficult to guess
which. But the basic point - that reductions in trade and migration will reduce
growth and productivity, relative to what otherwise would have occurred – is
very unlikely to be disproved, any more than the greenhouse effect.

So how should that
translate into how we actually make decisions?
Well, I listen to the weather forecast: but, like most Londoners,
whatever it says, I always carry an umbrella.
On the other hand, that doesn’t mean I’d buy a house on a flood plain.

Wednesday, 4 January 2017

The Financial Times annual survey of leading British economists' predictions, views and forecasts for the year ahead was published on January 3. Last year (that is, in January 2016) this is what I said about Brexit:

Q2: Brexit: If the British electorate vote to leave the EU in 2016, how would that: a) change your views about prospects for next year? b) Change your views about medium-term prospects?

I'd divide this into three:

a) short-term: relatively little visible impact. No doubt there would be some turbulence in financial markets, but I doubt we'd see much impact on the real economy in the very short-term (ie next year).

b) medium-term (ie the period of the negotiation over terms of exit and post-exit relationship between the EU and the UK, lasting at least 2 years). Significantly negative. These negotiations would be protracted, complex and probably acrimonious, leading to considerable uncertainty for both UK companies trading with the EU and international investors (not to mention EU citizens resident in the UK and vice versa). All this would be likely to have a substantial and negative impact on business confidence, business investment, FDI, and possibly trade and migration.

c) longer-term (post the negotiations and any transition) — impossible to forecast with any precision at this point, given we have very little idea of what the outcome of the negotiations in b) would be. The UK could undoubtedly survive and prosper outside the EU, and in some respects (flexibility on some aspects of trade and migration policy and regulation, reduced contributions to the EU budget) might benefit; but there are obvious and serious risks, in particular to trade in services (including financial services) which are vital to the UK economy and will become even more so in the next few decades.

Below are my detailed predictions from this year. I'm not a forecaster (and we have seen this year just how unreliable short-term forecasts can be) but they represent my best effort at providing some meaningful analysis of what we can expect over the next year. Come back next January...

1. Economic prospects

How much, if at
all, do you expect UK economic growth to slow in 2017? Please explain your
answer.

I would expect it
to slow somewhat in the first half of the year. What happens in the second
half depends very much on developments with the Brexit negotiations (as well
as events in the US and elsewhere in Europe). We could see reasonable if not
spectacular growth, but downside risks are large

2. Brexit

Compared to what
you thought 12 months ago about the UK's long-term economic prospects outside
the EU, are you now more optimistic or more pessimistic than you were?

Please explain your answer.

The strong
consensus amongst economists is that Brexit will make the UK significantly worse
off in the medium to long term - not disastrously so, but significantly. This
is backed up by a considerable body of theoretical and empirical evidence. Of
course, this evidence is based on historical data, and past is not
necessarily prologue; there is a high degree of uncertainty. But the
probability must be that Brexit will make us worse off. It is also important
to note that while economic developments since the referendum have certainly
not borne out the pessimistic forecasts of some institutions, that really
tells us almost nothing about long-term impacts - short-term forecasts are
made using very different methodologies to those used to estimate long-term
impacts, and (paradoxically) are much less reliable.

3. Inflation

Inflation has
started to increase in recent months. To what extent do you expect inflation
to rise in 2017?

If the exchange
rate stays where it is to about 3%. However, if it falls a lot farther
inflation could rise more (or conversely)

4. Monetary policy

In December, the
Monetary Policy Committee said the next interest rate move could as easily be
up as down. Will there be a shift in this monetary policy stance by the end
of 2017? Please explain your answer.

It is difficult
at the moment to see the next move being down , even if the economy worsens.
Barring negative shocks (which are quite possible) I'd expect the next move
to be up.

5. Immigration

Immigration is
likely to be central to the Brexit negotiations in 2017. How much do you
think immigration will change and what effect do you think this will have on
the UK economy?

My recent
research suggested that EU migration to the UK could fall by well over half
over the period from now to 2020, resulting in net EU migration falling by
more than 100,000. Both the state of the economy and the existence of free
movement of workers are significant determinants of migration flows. In
particular, free movement with the UK results in an increase of almost 500% -
that is, by a factor of six. It follows any significant restrictions on free
movement will reduce those flows. I also used the existing empirical research
on the impact of migration on productivity, growth and wages to estimate the
broader economic impacts of such a reduction. Over the period to 2020, the
resulting reduction in GDP would be about 0.7 to 1.3%, with a GDP per capita
reduction of 0.3 to 0.8%. By contrast, the increase in low-skilled wages
resulting from reduced migration is expected to be relatively modest.

6. Fiscal policy

Philip Hammond is
expecting government borrowing to fall in 2017. His new fiscal rules provide
headroom for more borrowing than currently forecast. To what extent will he
need to use it and why?

The OBR's fiscal
forecasts look relatively pessimistic; however the economic ones may be too
optimistic. Moreover, current spending plans for health and social care (and
perhaps education) look unrealistic. The NHS is clearly significantly
underfunded (it is basic economics that a richer, older society should, from
the point of view of overall welfare or wellbeing, spend a greater proportion
of GDP on health over time - the reverse has been the case over the past few
years.) It is not clear that such spending increases should be financed by
borrowing, but the government is unfortunately committed to a set of tax cuts
that have little economic rationale and will mostly benefit the relatively
better off. Some discretionary increase therefore seems likely.

7. Donald Trump

How do you think
Donald Trump's presidency will affect the UK economy in 2017?

This is
exceptionally uncertain, for obvious reasons. However, it does look likely
that US interest rates may now begin to rise steadily. This will put some
downward pressure on the pound and upward pressure on UK long-term rates,
which may well be unwelcome.